Month: June 2017

That article was published on 30/06/2017 by Philippe Goutière, ABIL, on Silicon Luxembourg.

Those who work in start-ups are usually some of the most talented people in their respective fields. And it is going to take all that talent to turn a business opportunity, the one in which they believe, into real value. But the flipside of opportunity is “risk”. Needless to say, that risks can have negative consequences and in some cases, destroy both the company and its founders in the shortest time.

While risk is an integral part of entrepreneurship, there are different ways to approach it. Entrepreneurs who succeed with their company over the long term have all one point in common: they are aware of the risks to which their business is exposed and have learned to manage them.

What are those risks?

There are obviously a multitude of risks and threats that affect start-ups. Early-stage companies are commonly said to face the following ones in particular:

financing risk: you can’t raise money when needed;

product risk: you can’t translate your concept into a working or attractive product;

business development risk: you can’t get deals with other companies;

timing risk: You are too early or too late to the market;

technology risk: you rely on poor systems; or

credit risk: your customers are not paying you in due time.

The more you grow, the more you discover additional risks. Just consider the following ones affecting companies at any stage of development: market risk, legal (regulatory) & tax risk, people risk, political risk or environmental risks…

What are the best practices?

The best practice can be summarized in one simple advice: Manage your risks!

“Risk Management” is the activity of thinking about what could go wrong in the company, and what are the best ways to mitigate the risk. Companies who have an adequate understanding of their risks are in a superior position to those who do not; on the long run they will outperform.

There are no exceptions, even for start-ups; they should implement a corporate governance including a strong risk governance element. Board is ultimately responsible for every activity within an organization. Together with senior manager, he should have a deep understanding of both the opportunities that the company is pursuing, and the risks that are related to them. He should ask the right questions, such as: what are the main risks we face? What is the likelihood of those risks occurring, and what would be the consequences for the company? How much of that risk do we want to (and are we able to) manage internally? …

In many instances, insurances will prove very useful risk management tools, by transferring the adverse effects of a risk to a third party. Some of those insurances are mandatory by law, others are taken out because of a deliberate decision of the risk management body within the company.

In the following articles, we will focus on some of the key risks that you may face in running your business. For each of them, we will consider both internal risk management and external risk transfer solutions. We hope you enjoy the reading.

If your company is involved in M&A transactions, or if your activities include the acquisition or disposal of assets such as portfolio companies and real estate, you are probably familiar with the concept of “Representations and Warranties” (R&W).

R&W are assurances given by the seller to a buyer about an asset and relating to various matters such as title, tax liabilities, employment, litigation or environmental issues.

Under the transaction documents, sellers are usually required to indemnify the buyer for breaches of R&W. That explains why those guarantees are often heavily negotiated and can form one of the most difficult aspects of the deal negotiations. Buyers naturally seek maximum protection from sellers while sellers try to minimize their liability in respect of the transaction.

If the buyer has concerns as to the creditworthiness or the ability of the seller to deliver on its promises, then security is usually sought. Sellers may need to arrange for guarantees or hold a portion of the sale proceeds in escrow to ensure that funds are available in the event of a breach, or to give the buyer the right to hold back and retain a portion of the payment. These options are however unsatisfactory for the seller, as they eventually prevent him from liquidating a fund or limit and delay returns to investors. Also, and notwithstanding the guarantees, the buyer may still feel uncomfortable with the level or security obtained.

In this context, Reps & Warranties insurance (further “R&W Insurances”, also known as Warranties and Indemnities Insurances) are considered as a great tool to facilitate mergers, acquisitions, divestitures and other business transactions. They supplement or replace the seller indemnity obligations by insuring all (or most) of the representations made within the Sale and Purchase Agreement (SPA).

Key policy features:

Policyholder: The policy may be purchased either by the seller or by the buyer.

Tailor-MadePolicy: policies are tailored to match the R&W negotiated in the SPA as closely as possible. There will be little difference between what could be claimed against the seller and what the seller (or the buyer as the case may be) can claim against the R&W policy.

Term: The policy term will run from the closing of the deal and for the full survival period negotiated in the SPA, or beyond if required.

Exclusions: They are usually limited to matters disclosed in diligence, intentional/criminal acts and fraud by the policyholder. Depending on the deal, insurers may want to limit coverage in respect of specific losses, such as resulting from breaches of covenants or forward-looking statements.

Covered Amounts: They are negotiated between the parties to the insurance contract. The insurance market as such has a capacity higher than EUR 500M.

Retention: The parties to the insurance will agree on a self-insured retention, to be borne by the insured. This is generally set at 0.5 % of the value of the transaction, but may vary depending on several factors, such as the industry, the size of the deal or the willingness to retain a higher part of the loss and consequently reduce the premium. For real estate transactions, the retention is more likely to be 0.1% of the transaction value.

Premium: The costs of these insurances typically range between 1% and 3% of the insured amounts. Factors such as the nature of the deal, the jurisdiction or the target asset are taken into account. Premiums are generally lower for real estate deals (0.8% to 1%) and titles guarantees (0.3%).

Benefits of a Buyer-side policy

When taken out by the Buyer, the policy shall pay them directly for losses arising out of a post-closing discovery of seller’s breach of a representation or warranty in the SPA. Buyer-Side policies:

supplement or sometimes substantially replace the indemnification provisions provided in the SPA;

extend the survival of certain R&W, if required up to seven years, which allows considerably more time to detect and effectively recover for post-closing losses;

offer additional protection to the buyer beyond the negotiated indemnities;

protect buyers against the collectability or solvency risk of an unsecured indemnity provided by a seller (e.g., a financially distressed seller, multiple sellers or cross-border transactions);

distinguish a bid over other bids in an auction process, by requiring a seller to provide short survival periods, modest liability caps and reduced escrow amounts for breaches of representations and warranties in a bidder’s draft purchase agreement;

preserve key relationships by mitigating the need for a buyer to pursue claims against management sellers, eventually now working for the buyer;

provide the buyer with a direct right of action against the insurance policy. No need to first seek recourse against the seller;

protect the buyer from fraud or misleading information by the seller.

Benefits of a Seller-side policy

Under a seller-side policy, the insurer indemnifies the seller for its indemnification obligations to the buyer, resulting from breaches of its R&W in the SPA. Seller-Side policies:

provide the seller with a “clean exit” by reducing or eliminating the need to establish escrows or purchase price holdbacks, thereby enabling the seller to more quickly distribute greater portions of the purchase price to its investors and eventually close the fund;

increase the purchase price obtained, while the buyer has full recourse under the warranties;

protect minority/passive sellers concerned with joint and several liability for indemnifying the buyer;

provide additional comfort for individual or family sellers;

provide a solution for situations where there is a lack of ownership history such as restructurings.

Practical examples:

A private equity firm wanted to exit its investment in a technology company at an enterprise value of EUR 500M. The buyer required substantive warranties with an indemnification obligation of EUR 50M, which the private equity owner was unable to give as it could not take on long-tail financial liabilities during the divestment phase of its fund’s life-cycle. Management of the technology company were prepared to warrant up to EUR 10M (representing 50% of their EUR 20M stake in the technology business).

Placing part of the purchase funds into a holdback escrow to cover potential warranty claims would prevent a clean exit for the private equity firm. On the other hand, the buyer was not prepared to consider a reduction in the consideration.

The buyer was able to purchase an insurance policy with a limit of EUR 40M to meet the total EUR 50M indemnity requirement. The policy was structured so that the buyer had to first pursue management up to their EUR 10M limit. The SPA therefore provided for a warranty cap of EUR 10M, backed by management’s escrow and the PE seller assumed no additional liability.

Why chose ABIL S.A. as your risk adviser or insurance broker?

ABIL is a Luxembourg based company specialized in risk management, advisory and insurance brokerage services, focusing in particular on companies active in the financial, advisory and technological sectors, as well as on large multinationals.

You may count on ABIL to tailor your R&W insurance policy to your specific needs and positively contribute to the success of the transaction. We also offer specific solutions to cover Tax liabilities, should there be a particular tax issue mentioned in your R&W.

We are at your disposal to address any question regarding and respond to any request for quotation.